The advent of Basel I capital adequacy proposal led to the growth of securitization transactions, as by making certain assets off-balance sheet, a bank could hold less capital on an overall basis in the Basel I regime. However, this led to an increase in the concentration of credit risk in the books of the concerned financial institutions. The credit risk related securitization transaction increases manifold if the underlying assets contain prepayment provisions, i.e., the borrowers are allowed to prepay their loans. This paper discusses the two alternative approaches that exist for assessment of prepayment risk in the case of securitization transaction. It also spells out the provisions contained in the Basel II accord regarding prepayment risk and capital allocation.

Asset securitization is a process in which a distinct legal entity, a Special Purpose Vehicle (SPV) issues securities (bonds) against an investment in an underlying pool of assets. The pool of assets serves as collateral to the securities. Pools can be of various types depending on the nature of the related assets. The assets are generally secured (e.g., automobiles, real estate or equipment loan), but in some cases they might be unsecured (e.g., credit card, consumer loans).

To initiate the securitization process, a pool of homogeneous assets, such as house building loans, credit card receivables or automobile loans, is created. Homogeneity is essential to enable a cost-efficient analysis of the credit risk of the pooled assets and to achieve a common payment pattern. The originator of a securitization scheme could be a bank or a financial institution. If a bank is the originator, it may take the assets from its own loan portfolio. However, in recent times, securitization of assets that are purchased from a third-party bank or that are non-bank assets (e.g., receivables of commercial companies) is becoming more prevalent.

In the second step, the pool is sold to a Special Purpose Vehicle (SPV) which finances the purchase by issuing securities backed by the pool of assets and which are the sole assets of the SPV. At that stage further, parties, together with a rating agency, are often involved in order to give advice to the originator, analyze the credit quality of the portfolio, and structure the transaction. If an underwriter participates in the securitization scheme, the securities may pass through his books before being sold to investors.

Prepayment Risk in Securitization Transaction: Assessment and Capital Allocation, capital adequacy, securitization transactions, off-balance sheet, financial institutions, risk and capital allocation, Special Purpose Vehicle (SPV), homogeneous assets, securitization process.